Two absurd departures from economic reality

COMMENT

Sven Giegold MEPSolvency II brings with it the much-needed modernisation of insurance supervision in Europe. But according to Sven Giegold, MEP and member of the ECON committee, it introduces two “absurd” and dangerous departures from economic reality: the Ultimate Forward Rate and the treatment of EU government, and now some local government, bonds as risk-free.

The Ultimate Forward Rate (UFR) is one of the cornerstones of the new Solvency II supervisory system. This discount rate determines the risk-free interest rate at the long end of the interest rate curve. The higher it is, the lower the mandatory reserves an insurer is required to have in order to meet long-term liabilities in connection with life insurance policies.

Because at the long end the market is illiquid, the interest rate is not calculated on the basis of market data, but extrapolated by EIOPA, which is required to define the risk-free interest rates as discount rates.

In this case, however, EIOPA has extrapolated a fanciful rate of 4.2%, which becomes the Eurozone standard for policies with a life of more than 20 years. This is specified in a recital of the Solvency II Directive; in the UK, meanwhile, the UFR is used only for policies with a life of at least 50 years. It is doubtful whether this decision was guided by the imperatives of regulatory prudence and economic plausibility. The fact is that a reduction in the interest rate, a move more consistent with market realities, would necessitate an enormous, but entirely appropriate, increase in the capital required to back life-insurance policies based on long-term guarantees.

Absurd, unbelievable and incomprehensible

Given this mismatch of the Solvency II UFR those authorities that can, are using a more realistic discount rate.

The Dutch supervisory authority has thus reduced the UFR for pension funds, which are currently not bound by Solvency II to 3.4%.

The International Association of Insurance Supervisors (IAIS) recently used a UFR of 3.5% as the basis for its survey of global systemically important Eurozone insurers.

This has given rise to an absurd, unbelievable and incomprehensible state of affairs whereby, for example, the German insurer Allianz is supervised in Germany and Europe on the basis of an UFR of 4.2%, but investigated internationally on the basis of a rate of 3.5%.

EIOPA overrides ESRB recommendation

In June of last year an ESRB staff working paper voiced similarly grave doubts about the excessively high UFR and recommended that it be lowered to somewhere between 3.2% to 3.7%.

But the national insurance supervisors are unmoved. At its meeting of 29-30 September 2015, the EIOPA Board of Supervisors decided that the UFR would remain unchanged until the end of 2016.

In so doing, EIOPA acted in breach of EU law. Article 47 of the Delegated Regulation states that the UFR should be determined in a “transparent, prudent, reliable and objective manner that is consistent over time.”

Despite all the good arguments emerging from the Netherlands, the IAIS and the ESRB, steady-as-she-goes is the watchword. The fear of undermining insurance markets with stringent long-term guarantees, such as those in Germany, Sweden or the Netherlands, was clearly too great. Instead, EIOPA is evidently hoping that ‘something will come up’ and save the day.

All the supervisors are behind this approach. Not one of them called for a different timetable, but at least in 2016 there will be a consultation on the topic. A decision on whether or not to overhaul the method for calculating the UFR is to be taken by September 2016, but the rate itself will still not be changed before the end of 2016.

For some time now, this attitude has left the staff of EIOPA and many supervisors and insurance companies shaking their heads. Because, in the final analysis, what is being undermined is the key principle underpinning the whole insurance industry: trust that the pledges made to policyholders can be met in the long term.

The German supervisor BaFin is also choosing to ignore the evidence. Its recent assessment that the sector is ‘well prepared’ is irresponsible.

It is also unrealistic because the CDU-CSU-SPD coalition government in Germany continues to refuse point blank to countenance an investment programme, which represents the only way of getting long-term interest rates moving upwards once again.

We Greens, in contrast, will continue to advocate a significant increase in private and public investment as part of a Green New Deal. Indirect subsidies for the insurance industry in the form of questionable public-private partnerships are subsidies that are both inefficient and detrimental to taxpayers’ interests.

Concerns over sovereign debt

Solvency II introduces another novel and disconcerting departure from economic reality. The treatment of government bonds issued in all the EU Member States as risk-free under Solvency II means that insurers are not required to retain capital against the risk of a fall in the market value of these bonds.

This is a completely absurd decision, given the heavy losses in the value of bonds issued in recent years by Greece and other EU Member States. It threatens financial stability and exposes policyholders to the risk of their insurers being unable to honour their commitments as a result of financial difficulties arising from investment in government bonds.

Acting on the principle that ’you can never get enough of a bad thing‘, the Commission has recently decided to make matters still worse by introducing statutory provisions listing those regional and local authorities that are to be treated in precisely the same way as central government for the purpose of calculating capital requirements. In other words, insurers are not required to retain capital in respect of bonds issued by them.

The list of relevant authorities is based on guidelines issued by EIOPA, which has, to this end, been given the task of assessing the regional and local authorities in terms of their fiscal powers and institutional provisions.

The list includes not only the German‚ Länder‘ (regions) and local authorities, but also the heavily indebted Spanish autonomous communities and the hard-pressed Austrian province of Carinthia, which is underwriting up to EUR 10 billion in loans to the failed Hypo Alpe-Adria-Bank.

As a result of this massive financial burden, Carinthia decided in March 2015 to commence preparations for possible insolvency. That this has not yet come to pass is due in part to hopes of financial concessions from creditors. At the same time, it manifestly belies the classification of Carinthia by the Commission and EIOPA as a risk-free debtor.

Striking discrepancies between insurance and banking

There are striking discrepancies between the list of regional and local authorities drawn up for Solvency II and for banking supervision, which should really be based on the same criteria. For example, the French regions, departments and municipalities are included on the former but not the latter.

These differences serve to strengthen the impression that the list of regional and local authorities has not been drawn up on the basis of objective criteria.

According to the Commission and EIOPA, the list is based on information provided by the national supervisory authorities, indicating that it might actually have come into being as a government wish list, despite the fact that the regional and local authorities concerned should have been the subject of an independent assessment by the Commission and EIOPA.

The European Parliament can do little to remedy the Commission’s inaction in this instance, since the Commission alone is responsible for technical standards. However, even if Parliament has no co-decision rights on this matter, Commissioner Hill, who is responsible for financial stability, must be called to account and I shall ensure that he is.

The author is an MEP for the Group of the Greens/European Free Alliance. The views expressed are the author’s own.

The text is based on articles published on Mr Giegold’s website.
Insurances/Solvency II: Fanciful interest rates: hope dies last,
8 January 2016
Start of Solvency II: Self-fulfilled government wish list,
8 January 2016

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  2 comments for “Two absurd departures from economic reality

  1. alanis
    January 22, 2016 at 08:52

    I do find it ironic that a member of the Green Party is advocating market consistent valuation, where insurers’ solvency and hence policyholder benefits are subject to the short-term vagaries of the financial markets, rather than the longer-term approach taken by Solvency II post the long-term guarantees package.

  2. January 22, 2016 at 10:05

    Your perceived Green irony is none. I do not advocate to replace the ultimate forward rate by market rates. At the very long end markets are thin and more importantly they have no clue what the risk free interest rate will be. But: More and more economists believe with good reason that risk free returns might stay low in mature capitalism. Therefore, the prudence principle requires to lower the ultimate forward rate in order to avoid that today’s beneficiaries of life insurances such as current pensioners, employees and owners take out benefits, bonus or dividends at the detriment of future policyholders. As always: Greens defend the fair and long-term view rather than the benefits of stakeholders in the short term.

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